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With interest rates rising, is now a good time to invest in income funds?

Two advisors answer this reader's question.

Is it now a good time to invest in income funds, with the rising interest rates? I ask because I have R1 million in living annuities, and I withdraw 4% p.a. quarterly. I would also like growth as close to inflation as possible. I am 77 years old, my wife is 72.

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Dear reader,

Thank you for posing the question, one that is asked quite often these days since the equity markets are in such turmoil.

The answer is a more loaded one than just a straight yes and no. Firstly, one must understand what happens to income funds when interest rates increase. Income funds consist of various underlying assets which act differently to interest rates.

Floating rate notes (FTNs) will benefit directly and mechanically from increasing (short-term) interest rates, as these instruments pay a spread over three-month Jibar rates (Johannesburg interbank average rate). Bonds, however, have an inverse relationship with interest rates, meaning that if interest rates go up bond prices go down and vice versa. This happens because the new bonds offer higher coupon payments, meaning the existing bonds must decline in price in order to be worthwhile investments to possible buyers. It is believed that in most cases the bond yields have factored in and discounted these increases already.

Keeping the above in mind one then has to look at the current inflation rate. The South African inflation rate has breached the target band of 3-6% for the first time since March 2017 and is now sitting at 6.5% as of the end of June 2022.

Your average income fund investment will yield around 7% per annum before any fees have been taken into account. Add to this calculation a drawdown rate of 4%, as mentioned in your question and you are facing the reality of depreciating your capital year-on-year.

In order to achieve your goal of growing as close to inflation as possible after your income drawdown has been taken into account, you will have to invest in a diversified investment. Different asset classes have different outcomes. Your cash and bond investments are good short-term investments with low volatility but also smaller chances of real growth. Property and equities (both local and global) are long-term growth assets with higher risks, volatility and rewards. Refer to the table below comparing the various portfolios over the last five years and each portfolio’s calendar-year returns.

An investment is not a once-off occurrence and must be evaluated and reviewed throughout the term. Adjustments will be needed from time to time. Income funds definitely have a place within an investment portfolio, especially for more conservative investors, but are not a viable long-term investment plan.

A qualified and experienced advisor can assist you in making the correct decisions, not making emotional changes at the wrong time and keeping your investment on track.

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Dear reader,

Thank you for your question.

Investors had a brutal year so far in the first half of 2022, as a result of the ongoing war in Ukraine and the Covid pandemic, consumer prices have reached their highest levels in decades and the US Federal Reserve hiking short-term interest rates to maintain inflation rates. Due to this many investors are trying to adjust their income to keep pace with inflation.

Just a brief explanation of income funds: An income fund is a type of mutual fund, exchange-traded fund or any type of fund that aims to provide income from investments.

The funds can hold bonds and equities. Income funds are mostly conservative but can be risky depending on the holding. Investors can easily invest in a diversified pool of securities that pay dividends or interest by using income funds. It’s vital to remember that the fund’s pricing is variable and subject to changes in the market.

The answer to your question is, with rising interest rates and considering your age, it is advisable to invest the bulk of your living annuities into conservative funds (income funds). However, since you like a growth close to inflation we suggest that you have some exposure to balanced and equities asset classes.

Being too conservative might not reach your investment goal of capital growth in line with inflation and you risk missing out on the appreciation you will get in the equity markets when they rebound.

Currently, the inflation rate is 6% and you are withdrawing 4% per annum, which means you need to achieve a real growth rate of above 8% per annum, making sure that you do not erode into the invested capital. Please also bear in mind that there are fees that are deducted from the growth of your investments.

Below is an example if you have 70% exposure to income funds and 30% to other funds.

    Annualised return
Funds Allocation 1 year 3 years 5 years
Equity Fund 10.00% 16.00% 16.00% 11.00%
Balanced Fund 10.00% 12.00% 10.00% 7.00%
Stable Fund 10.00% 10.00% 8.00% 7.00%
Income Fund 70.00% 6.50% 7.00% 8.00%
Weighted average cost and return 100.00% 8.35% 8.30% 8.10%
Returns are as at 31 May 2022, past performances are not a guarantee of future returns

*Please note we have used an average performance for each asset class based on a simulated model which however may not be indicative of future performance.

As seen in the above example, 30% exposure to other asset classes provides you with a return that is in line with inflation and provides you with long-term growth.

Inflation is one of the factors that the monetary authorities take into account when making a decision to change the interest rates. When inflation is high, the monetary authorities increase interest rates to discourage people and businesses from borrowing and spending too much money. This helps keep inflation on track.

When interest rates increase, investments such as high yield savings accounts, fixed deposits or any savings instruments look more attractive than equities. In this regard, investors tend to lock in profits made from equities by investing in high-interest rate investments. This equity sell-off will negatively impact the net asset value of the fund thus affecting the overall performance.

It is advisable to choose funds based on your own investment horizon and risk appetite. The idea should be to create a diversified portfolio that balances the asset allocation on your risk and return.

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